Carbonated Soft Drink Industry Analysis

by Wesley M 6 months ago in economy

How Do Coke and Pepsi Make So Much Money?

Carbonated Soft Drink Industry Analysis

Soda, Cola, Pop, Coke; it goes by a lot of names, but the industry standard is Carbonated Soft Drink (CSD). It’s one of the most profitable industries in the United States, and two companies control over 70 percent of the market. The Coca-Cola Company and PepsiCo, Inc are the main players in the CSD industry; but, being the biggest in an industry doesn’t guarantee a large amount of profits. In 2017 Coke made $1,283,000,000, and Pepsi made $4,908,000,000, so the question is:

How do Coke and Pepsi make so much money?

To find out we use a tool called Porter’s Five Forces: Power of Suppliers, Power of Buyers, Threat of Entry, Intra-industry Rivalry, and Threat of Substitutes

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First, we start by identifying the supply chain of the CSD Industry. Not many people know this, but the Coca-Cola Company, and PepsiCo don’t actually make soda; they make soda concentrate.

The CSD Supply Chain

Raw Materials => Concentrate Producers => Bottlers (glass, plastic, or aluminum cans) => Retail Chains => Consumers

In other words, Raw Material Suppliers sell basic materials to Concentrate Producers who create a mixture of soda concentrate using their own recipes. The Concentrate Producers then sell their product to Bottlers, and provide advertising to get the final product into Retail Stores. The Bottlers mix the concentrate with sugar and carbonated water before packing the mixture into either glass bottles, plastic bottles, or aluminum cans, and ship the final product to Retail Stores. The Retail stores put the products on display, and sell them to consumers.

We are looking at the Concentrate Producers to figure out how and why they make so much money by looking at the structure and operation of the industry supply chain through the lens of Porter’s Five Forces. It’s important to remember that Porter’s Five Forces is meant to look at an Average Firm in the market instead of looking at a specific company. However, since two companies dominate the CSD industry they’re also the average firm.

Force #1–The Bargaining Power of Suppliers

The suppliers in this case are the Raw Material Firms who provide resources to the Concentrate Producers to create the soda concentrate. For soft drinks, the Concentrate producers need caffeine, coloring, citric acid, and a few other basic ingredients.

(In Coke’s case, they have the actual recipe and ingredient list protected by a trade secret, but we do know there isn’t anything overtly special or rare to make them stand out from an average firm trying to make soda concentrate.)

  • Factor 1–Number of suppliers: there is a large amount of raw material providers, because the materials they’re selling are commodity-like. If one supplier starts raising rates on caffeine, then the Concentrate Producers can easily switch to another supplier to save costs.
    • Result: The Profit of the Concentrate Producers goes up because they save costs.
  • Factor 2–Distinctiveness of Products: as stated before, the materials are commodity-like; indistinct from one-another.
    • Result: The Profit of the Concentrate Producers goes up because they save costs.
  • Factor 3–Switching Cost (of the Concentrate Producer): I hate to reiterate, but the raw materials are so basic and indistinct that the switching costs for Concentrate Producers is very low. As long as it’s the same kind of sugar, it doesn’t matter who you get the sugar from, so Concentrate Producers pick the ones with the optimal costs.
    • Result: The Profit of the Concentrate Producers goes up because they save costs.
  • Factor 4–Threat of Forward Integration: This would be if a Raw Material Supplier decided to start making their own concentrate, and sold the concentrate straight to the bottlers. As stated before, Coke and Pepsi control over 70 percent of the market. That level of branding and advertising makes a huge difference in this industry, because it operates on an economy of scale (basically, the more you make of a product the lower your average cost per product is).
    • Result: The Profit of the Concentrate Producers goes up because they can generate more revenue due to market share control, and save on average costs because of economies of scale.

Final Result: The Bargaining Power of Suppliers is LOW.

Force #2–The Power of Buyers

The buyers for this industry are the Bottlers who buy the soda concentrate from the Concentrate Producers, and turn it into the final product you eventually buy off the shelf. Because they’ve operated for over a century (and because it was profitable to do so), Coke and Pepsi have purchased several bottling plants to streamline their processes, and save even more money. However, we’re going to ignore those integrated bottlers for our analysis.

  • Factor 1–Number of Buyers: there are over 300 bottling plants spread throughout North America. Since there are so many buyers, the suppliers (the Concentrate Producers) can play them off one another to increase their own revenue. For example, if I’m a manager for Bottling Plant A, and I pay Coke 48 cents per ounce of concentrate, but Bottling Plant B will pay Coke 50 cents per ounce, then Coke will obviously give their business to Bottling Plant B.

(By the way, I know making two cents doesn’t sound like a lot, but keep in mind that we’re dealing with millions of ounces of concentrate a year, so making an extra two cents is making millions of dollars.)

    • Result: The Profit of the Concentrate Producers goes up because they can charge more for their product.
  • Factor 2–Switching Costs (of the Bottlers): there are, functionally, only two Concentrate Producers (if you add on Dr. Pepper then the combined market share approaches 90 percent). Plus, bottlers are responsible for the costs of changing out equipment to service different products (i.e. changing a Coke line to a Sprite line).

It’s not well-known information, but Coke and Pepsi also have most of their bottlers locked into long-lasting and exclusive contracts, so even if bottlers wanted to switch to save money they’re not allowed to.

    • Result: The Profit of Concentrate Producers goes up, because they have control over the prices.
  • Factor 3–Threat of Backward Integration: this would be if a bottler decided they wanted to buy directly from the Raw Material Suppliers, and make their own sodas from start to finish. First, some of their contracts ban them from doing that. Second, the high barrier to entry in the CSD Industry, thanks to high marketing costs and brand power means it’s insane to try and compete with the leading firms in the market.
    • Result: The Profit of Concentrate Producers goes up, because there is little or no competition from members in the supply chain.
  • Factor 4–Profitability of Buyers: again, the buyers in this example are the Bottlers, and they make pitiful amounts of money. However, this means they actually have better bargaining power over prices, because they have hard limits on what they can afford to pay before they have to simply shut down production completely.
    • Result: The Profit of Concentrate Producers goes down, because the Bottlers have hard price ceilings to ensure profitability.
  • Factor 5–Fraction of Buyer’s Cost from Producer: this factor and the previous one go together. Close to 60 percent of the Bottlers’ cost comes from the Concentrate Producers, which, again, means they have more bargaining power.
    • Result: The Profit of Concentrate Producers goes down because the Bottlers have hard price ceilings to ensure profitability.

Final Result: The Buyer Power is LOW.

(Even though Bottlers have a little control over price, the long-term exclusive contracts, large number of competitors, and high barriers to entry means they basically pay the maximum price every time.)

Force #3–Threat of Entry

I’m going to save you some time since we’ve already covered most of the points in this section previously. The threat of entry involves outside firms entering the market as a Concentrate Producer. It is not a Raw Material Supplier or Bottler trying to become a Concentrate Producer, but the same logic still applies.

  • Factor 1–Economies of Scale: Benefits the Current Concentrate Producers because they have established systems and processes.
  • Factor 2–Switching Cost: Benefits the Current Concentrate Producers because current Producers have exclusive contracts.
  • Factor 3–Brand Differentiation: Benefits the Current Concentrate Producers because they already have established brands and can afford higher marketing costs.
  • Factor 4–Unfairness of Access to Distribution: this describes how being an incumbent in an industry gives you a competitive advantage over newcomers. Current Concentrate Producers have been in business for decades, and have options for direct delivery to consumers, fountain and vending options, and a large category of variants for their product. A new Concentrate Producer isn’t only competing with Coke; they’re competing with Coke, Coke Zero, Diet Coke, Coke Zero Sugar, Diet Pepsi, Pepsi, Pepsi Max, Pepsi Zero, etc.
    • Result: The Profit of the Current Concentrate Producers goes up because they have a competitive advantage of already being established firms.
  • Factor 5–Government Regulation: this doesn’t play a role in the CSD Industry. Later on we will discuss the Telecommunication Industry, where Government Regulation does play a large role.

Final Result: The Threat of Entry is LOW because incumbent firms have a competitive advantage to help exclude and discourage new firms while also increasing their profits.

Force #4–Intra-Industry Rivalry

  • Factor 1–Number and Size of Competitors currently in the industry: as mentioned before, there are functionally only two competitors in the CSD Industry. The CSD Industry exists as an Oligopoly (meaning only a few firms hold a majority of market share) which isn’t too far away from a Monopoly.
    • Result: The Profit of Concentrate Producers goes up because they spend less money fighting off competitors.
  • Factor 2–Industry Growth: the CSD Industry has actually been shrinking over the last few years because of rising health concerns from the consumer base. Just to remind you, we are looking at the profitability of the Soft Drink Industry, and not Coke or Pepsi, so we ignore Coke and Pepsi’s other products that exist outside of the CSD Industry when evaluating this factor.
    • Result: The Profit of Concentrate Producers goes down because of a shrinking market size.
  • Factor 3–Brand Differentiation: We already covered this; Concentrate Producers benefit.
  • Factor 4–Perishability of the Product: the primary ingredients in the final soda is water and sugar in a non-degradable package like plastic, glass, or aluminum. Plus, Concentrate Producers are making their product and shipping it to Bottlers relatively fast, so they definitely have low storage costs.
    • Result: The Profit of Concentrate Producers goes up because they have low storage costs.

Final Result: Intra-Industry Rivalry is LOW.

(It's important to note that rivalry between Coke and Pepsi is high, but remember, we're looking at them both as a single entity to represent the entire CSD industry. When you look at them as a single entity, they have no real competitors.)

Force #5–Threat of Substitutes

  • Factor 1–Value Offered by Substitutes: in this case substitutes are not buying a Sprite instead of buying a Pepsi. Substitutes are things that fulfill the same need as a soft drink like a sports beverage, water, coffee, or juice. All of those substitutes provide a similar value at a similar cost to consumers, which means Concentrate Producers (of soft drinks) face a huge threat from substitutes.
    • Result: The Profit of Concentrate Producers goes down because they have to spend more in advertising, and make less from sales due to high value from substitutes.
  • Factor 2–Switching Cost for Substitute (of the Consumer): this cost is basically nothing or consumers. In the United States, it’s funny how a bottle of water can cost the same as a bottle of Coke, but since they both fulfill the same basic need (thirst) consumers regularly switch between the products.
    • Result: The Profit of Concentrate Producers goes down because they have to spend more in advertising, and make less from sales due to high value from substitutes.

Final Result: Threat of Substitutes is HIGH. Soda is a drink that tastes good, and there are plenty of options to fulfill that need for a consumer.

Summary

For Concentrate Producers, the Carbonated Soft Drink industry exists as an oligopoly with extremely high barriers to entry, tight price control over the supply chain, and easy avenues to reduce the threat of substitutes. The dominating Concentrate Producers can easily merge, and acquire bottling plants to reduce costs, and start producing their own versions of substitutes like juice and sports drinks to erode the competition they would feel from substitutes for their carbonated beverages.

New firms will find it next to impossible to see the same level of success as incumbent firms, because Current Concentrate Producers enjoy the benefits of powerful branding, and economies of scale to preserve and grow their market share. Because the Bargaining Power of Suppliers is Low, the Buyer Power is Low, the Threat of Entry is Low, and Intra-industry Rivalry is Low, Current Concentrate Producers can drive profitability from business operations.

Regarding the Coca-Cola Company and PepsiCo Inc, they have successfully made moves to secure their growth and market share despite the shrinking market for carbonated soft drinks. Both firms operate large bottling enterprises, and produce their own substitutes to their flagship cola products. Both firms continue to acquire competing firms within their realm of experience of consumer beverages by buying international coffee brands, and at-home soda making brands.

If you want to make money in the stock market, Coke and Pepsi have been around for over 100 years, and they'll probably be around for another 100 more.

economy
Wesley M
Wesley M
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Wesley M

21. Entrepreneur. Author. I am blessed with a brain that excels at analysis which means I'm really good at evaluating businesses, compiling researched information, and figuring out the plot of almost any movie from the trailer. 

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